Hedge funds are non-existent. Other active investors like private equity players rarely confront corporate management with a view to improving governance. Pension funds are practically non-existent. Investment restrictions prevent provident funds from playing an important role in the financial markets. Indian investment banks are poorly capitalised.

Much of the invest-able funds are with the state-owned insurance behemoths. Together with the private sector players, who are growing fast, they could contribute to the development of a corporate bond market if (and it is a ‘big if’) investment restrictions were moderated. Some of the public sectors banks (PSBs) suffer from an inability to attract adequate human capital for skilled tasks and an inability to incentivise performance, which limits their ability to develop strong risk management systems. In turn, this hampers their ability to create new and appropriate products for households or to invest effectively in the riskier part of the spectrum of assets.

State ownership of financial institutions is a major factor that inhibits competition. This is compounded by the need for regulators to take into account the incentive structures and special circumstances that come from being government-owned. Restrictions on ownership and shareholding inhibit competition and innovation too. This applies especially to institutions like banks and exchanges, clearing corporations and depositories. Limits on how much shares an individual shareholder can hold (five per cent in exchanges, 10 per cent cap on voting rights in banks) and limits on ownership by foreigners makes it difficult for new institutions to come into being and for shareholders to exercise influence on management. This reduces competitive pressures on incumbents and slows down the pace of development of market institutions.

Most such restrictions have been introduced to ensure that such institutions remain in the hands of “fit and proper” persons. They are a recognition of the perception that the regulatory system is too weak to prevent misuse of management authority and the only way to prevent institutions from falling into “wrong hands” is to have rules on concentration of ownership. However, the costs imposed by these rules are prohibitive.

In short, says the Report, “The deficiencies in Indian financial markets stem from missing markets and missing actors”. The way to address the deficiencies lies in opening markets, equalizing market rules for all kinds of participants and in removing rules that ban specific players only from certain activities. It is relatively easy to resolve this problem. However, the second problem, viz., missing actors, is deeper and requires more long-term efforts - that of improving the capabilities of financial firms. The way to do this is to increase competitive pressures in the market ecosystem by removing constraints in the way of entry of new players.

The Report also says that infirmities in regulation render financial markets illiquid and inefficient. It cites the ‘silo model’ that obtains in India. In the said model, financial markets are broken up across SEBI, RBI and FMC. There are hard constraints that separate firms and players in one silo from operating in other silos. These constraints reduce competition, hamper economies of scale and scope and impede the flow of successful institutional arrangements and ideas from one part of the financial markets to others.

Steep barriers to innovation obtain too. New ideas are banned unless explicitly permitted. A great deal of what would be considered ordinary activities in global finance is incompatible with extant laws and subordinate legislation. In a well-functioning market economy, firms are constantly on the lookout for new ideas in designing products and processes so as to reduce cost and better serve customers. A firm that comes up with an innovation enjoys a temporary advantage and enhanced profitability until competitors catch up with it. In Indian finance, the glacial pace of change has given out signals to financial firms that the rate of return on innovation is meagre. Approvals take years and so there is no question of obtaining a temporary elevation of profitability by innovation!